The difficulties of institutions that need cash for payment have grown acute
during the chalk-brained professors' zero-interest-rate pogrom. Insurance
companies are one victim, pension plans another. Looking specifically at
defined-benefit pension plans, the plan sponsor (corporation, maybe, or
municipality) is obligated to pay current and future retirees a specific dollar
amount from now until a spouse's death.
The discrepancy between income received from investments and cash needed to pay
beneficiaries of public (state, municipal) pension plans dumbfounds the
mathematically inclined. Actuaries make long-term projections of returns on
assets and the change in liabilities. The assets on hand to pay benefits in
2025 will not look as susceptible to downgrade if the actuary projects annual
investment returns at 8% rather than 3%. Thus, 8% is a typical investment
return projected on plan assets today. High-yield bonds are often a sanctuary
to justify such assumptions. Now in our fifth year of interest-rate
confiscation, such bonds are bought, then bid up for their yields, thus
compromising the virtue of such holdings since the higher prices drive the
yields lower.
Investment managers supply what pension funds want. It has been a curiosity
that private-equity funds, that do a little bit of everything today, have been
buying houses in quantities not seen since the Bolsheviks annexed Moscow. Among
others, Texas Pacific Group (TPG Capital Management LP) is planning to buy at
least $1 billion of real estate later this year. Others with similar
initiatives, who are known better for buying companies, taking them private,
then selling them back to the market, are Blackstone Group, Carlyle Group, and
KKR. Other than the certainty that most similar organizations, be they
private-equity firms or banks, spend more time looking at their competitors
than at the investment, thereby misestimating the end of the cycle, why might
there be this lurch for houses in 2013?
Art Cashin, at UBS wondered the same, and asked one of the "very
smartest" investors he knows. He quoted his informant in the March 15,
2013, "Cashin's Comments":
"The more headlines I see like this [TPG buying $1 billion of
real estate - FJS], the more I think these mega fund managers (KKR, Carlyle,
Blackstone, Apollo) are gearing for the next leg of the MACRO economy. My
opinion, this aggressive move into real estate is not just allocating capital
to take advantage of a distressed sector. Funds managing $50 to 100 billion and
more in some cases have determined that there is just not enough hedging
product (CDS, options) to offset massive positions in private equity, credit,
etc. I believe they have made the bet that economic theory has not changed that
much in 500 years and the next leg will be much higher interest rates and
consequently inflation. What is the poor fund manager to do when he has been
forced to hold largely illiquid securities (private equity, credit)? Find a
hedge. With none available at 35,000 feet you move to 70,000 feet. Hard assets
combined with LONG term financing. I would guess that these funds are borrowing
as much as possible in the debt markets for as long a duration is possible.
(Not just funds, Disney and others have 100 year bonds)
"Conclusion, smart money is betting on coming inflation,
possibly hyper-inflation. Hard assets and long term borrowing prudent at this
point. Thesis supports a bid under real estate, so bubble is not imminent. Buy
as much real estate as possible, borrow as much as possible (FIXED RATE), for
as long a duration as possible.
"And of course, stay very nimble with a tip of the
hat......"
"The next leg" of inflation is
apparent all day long: subway, parking, magazine, soup, sandwich, oil change,
groceries: from $3.29 to $3.69, a seven-ounce rather than nine-ounce serving.
The collective American mind, having been told otherwise for so long, may, in a
flash, think: "it's 1973!" and the concerted efforts to inflate
assets ("massive positions in private equity, credit, etc.") will
come undone when the real costs of living are hot news.
It is impossible to hedge an entire
market. The Smart Investor surmises Big Money is preparing and is buying the
least bad alternative (for a company managing $100 billion). They are borrowing
at miniscule interest rates, as much as possible, at a FIXED RATE, and buying
long-term assets that may get squashed in the short- to middle-term. The
squashing is a worst case, not assured, but one the investor should consider.
When interest rates rise ("they have made the bet that economic theory has
not changed that much in 500 years"), the value of assets, which are
priced now for no interest costs, could - surprise a lot of people.
The May 15, 2013, Wall Street Journal
published a laundry list under the title: "Private Equity Firms Build
Instead of Buy." The heart of such an approach was expressed by David
Foley, head of energy investing at Blackstone Group LP: "We always look at
our returns as buy and hold forever, because you might."
Blackstone, teaming up with the Aga Khan
Development network, built a new dam at the headwaters of the White Nile. The
dam produces almost half of Uganda's electricity which Blackstone sells
"at rates that ensure profits for Blackstone for years to come."
David Foley may have frowned when reading
"ensured," since there are untold contingencies that could disrupt a
steady flow of profits. Speculating a bit here, a pension fund may invest in
Blackstone's project and be permitted to log an 8% (for example)
return-on-investment each-and-every year, for the next 30 years, or, until the
dam is sold. Should evil spirits temporarily halt the flow of electricity ("rituals
had to be performed to appease spirits.... A feud between two diviners who laid
competing claims to remove the spirits went on for two years"), the fund
may still be permitted to log an 8% return, given the long-term objective.
The Wall Street Journal story
discusses other such projects: "Blackstone is pursuing similar dam
projects elsewhere in Uganda, in Tanzania and along Rwanda's border with the
Democratic Republic of the Congo. Using its power-plant builder Sithe, the firm
has plants under construction in India and the Philippines.... Apollo [Global
Management], for its part, is managing the investment of money that small
savers put into fixed annuities promising them a steady rate of return.... KKR
is developing a tract of houses and apartments in Williston, N.D., for the oil
workers pouring into that region.... [KKR] has teamed up with Chesapeake Energy
Corp. to drill for oil for years to come."
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